Index Futures

		What about index futures?
		What is hedging effectiveness?
		Why not form a small portfolio of the ten most liquid stocks, and work to ensure that the small portfolio is maximally correlated with the S&P CNX Nifty?

What about index futures?
NSE commenced trading in Index Futures on June 12, 2000. The Nifty futures contracts are based on the popular market benchmark S&P CNX Nifty Index. S&P CNX Nifty is uniquely equipped as an index for the index futures market owing to (a) low market impact cost and (b) high hedging effectiveness. The good diversification of S&P CNX Nifty will generate low initial margin requirements. Finally, S&P CNX Nifty is calculated using NSE prices, and NSE is the most liquid exchange in India, thus making it easier to do arbitrage for S&P CNX Nifty index futures.

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What is hedging effectiveness?
Suppose you have some portfolio, and you use index futures for hedging. A good index is one, which gives high hedging effectiveness, i.e. the index should correlate well with your portfolio -- whatever it may be. A good index would give a very high risk reduction when a portfolio owner short sells the index futures. S&P CNX Nifty correlates better with all kinds of portfolios in India as compared with other indices. This holds for all kinds of portfolios, not just those that contain index stocks.

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Why not form a small portfolio of the ten most liquid stocks, and work to ensure that the small portfolio is maximally correlated with the S&P CNX Nifty?
This can, indeed, be done. Is it worth doing? That depends upon the cost and benefit. Calculating the weights, in the ten stocks with the lowest market impact cost, so that the correlation with S&P CNX Nifty is maximised, is not easy to do. (See Risk structure of Indian stocks by Dr. John Blin of Advance Portfolio Technologies APT - http://www.aptltd.com  for a calculation of a 10-stock portfolio which is maximally correlated with S&P CNX Nifty. This is found in the book "The future of fund management in India" edited by Dr. Tushar Waghmare, "Invest India" - Tata McGraw Hill Series, 1997 - http://www.iief.com)

The gains from such an activity are not large. S&P CNX Nifty is explicitly designed to make it convenient to trade complete index portfolios. This is in contrast with other markets, where indices have arisen before index futures came about, and ways had to be found to trade them. For example, the S&P 500 index was there before index futures came about. When index futures started trading, arbitrageurs had to find ways to trade the index - trading 500 stocks on the floor-based New York Stock Exchange was highly cumbersome. This led to great creativity in finding 250-stock portfolios which correlate well with the S&P 500. In India, there is no need to undergo these kinds of problems. S&P CNX Nifty is the base of the index futures, and S&P CNX Nifty is designed to be convenient to trade directly.

Last updated on March 10, 2008.